The storming rally in credit derivatives hit reverse gear on Tuesday, as momentum failed and investors drove up the cost of protecting debt against default.
With equities falling, dismal earnings from US aluminium-maker Alcoa and persistent calls from credit strategists that the rally was overdone, credit default swap spreads finally bowed to the pressure.
The cost of insuring the debt of the mostly junk-rated companies in Europe’s iTraxx Crossover index jumped 19 basis points to 488bp, having fallen by almost 100 basis points this month, and 200bp since its high in March.
In the US overnight, the CDX index of investment-grade credits widened by 3bp after Alcoa said its first-quarter profit halved from a year ago; a reminder that the first quarter earnings season, which kicks off in earnest next week, could be a sobering one.
Analysts said the rally, which was characterised by low trading volumes and little positive news, had simply petered out.
“It’s not so much that a single event has triggered the shift, but a realisation that we had a period of good performance without much real conviction – that couldn’t go on forever,” said Willem Sels, credit strategist at Dresdner Kleinwort.
Mr Sels said in a note to clients on Tuesday morning that he thought the European indices had gone “from cheap to expensive too quickly”, and that his team was buying protection on the iTraxx Europe index at 92 bp.
That trade was already in the money by midday, as the index – which measures the cost of protecting 125 investment-grade credits against default – widened 9bp to 95bp.
This means it cost €95,000 per year to insure €10m of iTraxx Europe debt over five years.
But Mr Sels cautioned that so far, the move wider also lacked real conviction: “It might take a bit more time to say my trade is successful. For a real jump wider we need negative macroeconomic data from the US at the end of the week.”